‘Sellers strikes’, gilts and QE

On the first day of the Bank of England’s resumption of gilt QE, after the central bank had put its monetization of bonds on hiatus in 2012, bondholders were perfectly happy to offload to Mark Carney bonds that matured in 3 to 7 years with 3.63 offers for every bid of the £1.17bn in bonds the Bank wanted to buy.

However, this week (Tuesday, 9 August) when the BoE tried to purchase another £1.17bn in bonds, this time with a maturity longer than 15 years, it failed to get the stock it wanted despite not setting a price limit and it acquired only £1.118bn worth. The BoE’s second open market operation was, therefore, uncovered by a ratio of 0.96.

There are several issues behind this “sellers’ strike”. First, bonds with more than fifteen years to maturity are much sought after by pension funds seeking to “hedge” liabilities, and it’s not obvious why an investment community berated for not doing more to control the risks, as defined by regulation, would want to realise cash – which they’d then want to re-apply to the very assets that they’d just sold.

Secondly, the fact that there weren’t enough sellers at any price means that prices may well be squeezed higher yet as, of course, prices are set by the last transaction, and price here is therefore nothing to do with ‘value’ but is a function of flawed markets and regulations.

And then there are the market and international contexts. Within the UK, the thirty-year yield at 1.37% looks bonkers in the context of likely long-term inflation trends and the BoE’s inflation target of 2% but it does represent a significant yield premium over the two and ten-year yields, now at record lows of 0.10% and 0.69% respectively.

If we say that the first ten years of a thirty-year bond’s life is due 0.69%, to get to the full life return of 1.37% for thirty years, implies that the last twenty years compound at 1.71% – that’s not high but it is a noticeable improvement on the headline rate.

Meanwhile, the BoE already owns a third of the gilt market so the free float is already smaller than many expect. As for the international context, the German thirty-year yield is 0.46% so the annualised excess yield for holding gilts is significant and indeed substantial as a percentage of the yields on offer.

Endgames

As we know the BoE’s intention is to nail yields to the floor to encourage investment and spending, and to drive cash into the hands of investors, with hope that the cash flows into investing and spending.

Part of the investment angle is to get savers to take more risk – so we have central banks generally herding savers, who are encouraged to buy riskier assets to get a forward cash flow return and the prospect of beating long term inflation.

This suggests that the length and magnitude of the current equity market rally may be far greater than what many expect.

It’s hard to say what would be an appropriate multiple for the broader stock market when risk-free rates are negative in real terms but the answer is higher than many think.

This isn’t the only “call” – renowned US investor Stan Druckenmiller made a speech in May titled The Endgame and said: “Not a week goes by without someone extolling the virtues of the equity market because ‘there is no alternative’ with rates at zero.

“The view has become so widely held it has its own acronym, ‘TINA’.”

He warned that valuations are too high and the economic outlook is looking increasingly precarious: “Three years ago on this stage, I criticized the rationale of Fed policy but drew a bullish intermediate conclusion as the weight of the evidence suggested the tidal wave of central bank money worldwide would still propel financial assets higher.

“I now feel the weight of the evidence has shifted the other way; higher valuations, three more years of unproductive corporate behavior, limits to further easing, and excessive borrowing from the future suggest that the bull market is exhausting itself.

“If we have borrowed more from our future than anytime in history and markets value the future, we should be selling at a discount, not a premium, to historic[al] valuations.”

Druckenmiller’s investment conclusion was to short stocks and buy gold. Since his speech, the S&P500 is up 6.3% while gold is up 4.5%.

Buybacks & the bond obsession

Interestingly, if we study the details, the true story is that investors faced with falling yields have been more obsessed with bonds than stocks, and the flood of money going into bonds has indirectly fuelled the bull market in stocks by financing stock buybacks.

Since the start of the bull market in stocks during Q1 2009 through Q1 2016, S&P500 companies purchased $3.0tn of their own equities, and over this same period, non-financial corporations repurchased $2.6tn of their shares and issued $2.0tn in bonds on a net basis.

There is then a scenario where corporations continue to buy back their shares and to engage in M&A deals with a buying panic driven by individual and institutional investors who conclude that interest rates could stay near zero for a very long time with no recession in the foreseeable future.

Such investors scramble to buy dividend-yielding stocks, especially of companies that have a history of increasing those dividends.

To attract investors, companies that haven’t paid dividends start to do so, and those that have paid dividends but haven’t increased them for a while start to do so too. Stock valuation multiples soar as investors view stocks as cheap relative to the valuation of bonds.

Meanwhile, institutional investors have been net sellers of US equities during the current bull market. Foreign investors were net buyers until the past year, when they sold $206bn through Q1.

Since the start of the bull market during March 2009 through to June, combined equity funds in the US attracted $1.2tn whilst over the same period, combined bond funds attracted $1.9tn.

The preference for bonds over equities has been increasing – over the twelve months through to June, combined bond funds attracted net inflows of $145bn, while combined stock funds attracted only $59bn. Altogether, stock and bond funds in the US (including ETFs) attracted $3.1tn since March 2009.

But whilst the Fed’s policy of “financial repression” has forced investors into stocks and bonds, and investors have enjoyed significant capital gains, this wealth effect has yet to stimulate as much growth as the Fed would have hoped.

Forward earnings

Looking forward, there is anxiety about the richness of valuations. The Fed’s Stock Valuation Model compares the forward earnings yield of the S&P500, currently 5.84%, to the 10-year Treasury bond yield, currently 1.50%.

The reciprocals of these numbers show that stocks are selling at a forward P/E of 17.1, while bonds are off that chart with a valuation multiple of 64.9.

But while investors are worrying as to whether stocks are still cheap or bonds are grossly overvalued, most corporate finance managers can have no doubt that the after-tax cost of borrowing in the corporate bond market is well below most forward earnings yields. That gives them a tremendous incentive to continue buying back their shares.

If the forward earnings yield fell to the current after-tax borrowing rate of 3.4%, the S&P 500’s P/E would be 29.4. In other words, valuations can go higher even without a buying panic by investors. If the dividend yield of the S&P500 dropped from 2.04% currently to match the 1.50% of the bond yield, that index would be up 36%.

As for affordability, in the world of corporate finance, there is enough internal cash and borrowed cash to more than cover capital spending, leaving plenty of money to buy back shares and corporations can also increase dividends.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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